Balance sheets: Making CoCos popular

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Conversion-free notes could be a watershed moment in the repair of European bank balance sheets.

After the past few tumultuous months that Barclays has had, the bank may not be considered in the fittest of states to show other banks a way forward.

But the novel structure and success of its sale of $3 billion of contingent convertible notes, or CoCo bonds, in November could provide a very handy blueprint for other banks to use.

Indeed, at a time when investors remain decidedly skittish about bank capital levels, and in particular about the prospect of dilutative equity injections or even nationalization among weaker peripheral banks, Barclays CoCo’s may be a watershed moment in the balance sheet repair of Europe’s banks, says BAML European investment strategist John Bilton.

In the few CoCo’s that have been sold in Europe thus far by banks such as Rabobank, Credit Suisse, UBS and Lloyds, investors receive a high coupon in return for conversion to common equity if capital ratios fall below a "trigger level", usually linked to core tier-one ratios.

But Barclays CoCos are different. At the trigger there is no conversion to stock. Instead the principal is fully written off, which means total wipe-out for bond investors while the issuer’s shareholders remain intact.

Investors in the CoCo bonds of UBS also face being wiped-out in this way, but its trigger-level is considered low at 5%, whereas Barclays’s trigger is considered high at 7%.

Barclays is currently operating with a tier one capital ratio of 11.2% and by the end of 2013 it aims to have a 12.1% ratio under slightly different Basle III regulations.

As such, Barclays is the first bank to sell a high-trigger, total-loss instrument to new investors, and boy did investors like what they saw – demand was said to have hit $17 billion, with hefty interest from Asian buyers.

Given its success, could Barclays’ CoCo be a template for other big banks? Possibly.

There are two key macro level takeaways from the Barclays CoCos, which were priced at par to offer a juicy 7.625% yield, and that will cost Barclays £140 million a year to service.

First, credit investors are so starved of yield that they are willing to risk a total loss of principal, albeit with a large capital cushion, in return for such a nice yield.

Second, since CoCo investors lose their principal before stockholders, the bonds essentially sit below equity in the capital structure. So, the bonds improve Barclays’ core tier one capital position in a way that is non-dilutive for shareholders even in a crisis.

As such, Barclays could then provide a template for other big banks in the eurozone to issue similar structures, and thereby help shore-up investor confidence in the banking sector without dilution.